Two years ago, at the height of the corporate scandals that took down WorldCom, Adelphia, and Enron, and roiled others from Tyco (NYSE: TYC ) to MicroStrategy (Nasdaq: MSTR ) , Congress rushed through a bill designed to address much of the abuse of shareholders at the hands of corporate ne'er-do-wells. Not ones to stand in the way of an enraged citizenry, politicians fell all over themselves to appear strong on the issue of big-time corporate fraud. President Bush eagerly signed the bill, and with that the Public Company Accounting Reform and Investor Protection Act, better known as Sarbanes-Oxley, came into law.
There were people who were squawking about the fact that Congress had rushed the bill through without getting it right. There were others who noted that Sarbanes-Oxley would add a substantial financial burden to public companies without actually providing much in the way of protection to investors. It turns out that these people were right. Even Paul Sarbanes (D-MD) has railed on companies for their procedural, rather than holistic adherence to the new law.
In almost every situation when laws are being made on Capitol Hill, lobbyist groups are trained to cavil about any slightly negative outcome as being the equivalent of gunning down grandmothers. That people were screaming about the headache of following Sarbanes-Oxley wasn't noteworthy. That the ones who harped about the burden on corporations turned out to be right is something else entirely. Surveys estimate that companies with less than $100 million in revenues can have more than $500,000 in additional auditing costs each year to comply with Sarbanes-Oxley. That's a big burden; many smaller companies are weighing the option of going private, and many currently private companies that were considering public offerings have elected not to do so. They're changing plans in part because the cost of annual reporting for public companies has risen to the point where it outweighs the benefit of having access to the equity markets. In effect, Sarbanes-Oxley and the implementation thereof has increased, across the board, the cost of new equity capital to levels that some smaller companies are finding unacceptable.
This past year, a company I owned, Mobile, Ala.-based publisher Integrity Media, made the decision to go private. Integrity has revenues of about $70 million, but its management had long fretted that the market was undervaluing its stock. Integrity was too small to attract analyst coverage that it didn't have to pay for, had its stock priced at levels that would make any transaction where new Integrity shares were used as currency extraordinarily dilutive to existing shareholders. So to sum up: Being public required a large number of man-hours to prepare filings, had a cost that was a sizable percentage of the company's earnings, attracted minimal interest, and kept the company's share price easily measurable and low. To Integrity's management, it just wasn't worth it, so in November 2003 a takeover team led by CEO P. Michael Coleman announced that it intended to take over the company at a premium exceeding 60%. The deal closed in early July, and Integrity Media trades no more. Was Integrity Media the next Home Depot (NYSE: HD ) , a company that started as a micro cap and grew into a $75 billion behemoth? Probably not, but if it is, the benefit of its growth won't accrue to outside shareholders -- there aren't any.
There are all sorts of conflicts when a management team elects to take a company private. Managements, being rational buyers, aren't very interested in overpaying, so they tend to make offers to take the companies they run private at times when stock prices are depressed. But since managements have some control over the information upon which stock values are based, it would not be very hard to make accounting choices prior to announcement of the privatization bid to make their companies look worse than they would if the accounting treatment had been consistent. A management buyout is fundamentally different than an acquisition by another company. In the former, the managers are sellers; in the latter, they're buyers. This week, Cox Communications (NYSE: COX ) announced that its controlling shareholders wanted to buy the portion of the company owned by the public. The price they offered was a 16% premium on the previous close. What are the odds that the managers thought that this premium to the trading price wasn't a premium to the company's true value?
That's not to slam Cox -- its management is acting like rational buyers, ones who no longer see the benefits of being public outweighing the costs. Cox isn't part of the small-company stampede, though. Another company rumored to be considering going private is Martha Stewart Omnimedia (NYSE: MSO ) . The drive to do so in this case is simple -- Martha Stewart's conviction precludes her from serving as an officer or director of a publicly traded company. Take Omnimedia private and that problem takes care of itself -- at least at her namesake company.
But the real movement for companies going private is in the small- and micro-cap areas of the market. Companies such as Boyd Brothers Trucking (Nasdaq: BOYD ) , Webco (AMEX: WEB ) , and ASA International (Nasdaq: ASAA ) are finding that they have little real benefit in being public companies and find the process to be a time-consuming and evermore expensive drain on their resources. And the process for going private itself is not that easy: Boyd announced its intentions to undergo a management buyout in December 2003 at $7 per share but has since had to raise its offer to $9.18 per stub. But companies are increasingly finding that the burden of costs of regulatory compliance far outweigh the benefit of being public.
That's a problem. Naturally, investors want sufficient information to be able to make informed decisions about the companies they own. But if the burden is so great on companies that the "next Microsoft" is leaving the public exchange rather than expending resources to meet them, that's not necessarily a good outcome. Sarbanes-Oxley was thrown out there to address what was certainly a torrent of horrible corporate actions and a general decline in professional standards of accountancy. But like any laws, this one is limited by people's willingness to observe it. The evidence at this point shows that Sarbanes-Oxley, though certainly fraught with good intentions, is creating little more than procedural hoops through which companies must jump. These hoops promise to become weightier and more expensive as time goes by. And many small companies are electing to avoid the hassle and expense altogether. Certainly, for many, this is a good decision -- if they have no need for equity financing, then there's not much point. But for others, they're making the rational decision to remove themselves from the stock market because the expense of staying on is simply too great. This cannot possibly be a good thing.
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